Families are being warned they face a staggering 70% tax on their pensions following Labour’s Budget set out by Rachel Reeves.
A financial expert has warned over ‘the great pension tax raid of 2024’ which could see some pay an effective 70.5 percent tax rate on their pensions thanks to a combination of announcements over changes to Inheritance Tax and Income Tax relating to pensions.
Andrew Marr, managing partner at tax consultancy firm Forbes Dawson, said the Budget changes could have ‘a devastating impact on family finances’ when a loved one dies.
Chancellor Rachel Reeves announced on Wednesday that pensions would begin to be counted in Inheritance Tax
Currently, when someone dies aged over 75, there is no Inheritance Tax on their pension pot but there will be income tax for the beneficiaries to pay at their marginal rates.
Mr Marr said: “I, therefore, concluded that HMRC would take a 40% tax payment immediately and leave beneficiaries with the remaining 60%. That may have been fair.
“It is now clear that what was actually announced was a tax of up to 70.5% on unused pension funds.
“Under proposals to take place from 6 April 2027, after the initial 40% tax hit, beneficiaries will still be subject to income tax at their marginal tax rates on anything further that they withdraw.”
Forbes Dawson then gave an illustration which shows the issue.
Bill died with £4m in his pension scheme. He had £2m of non-pension assets and inherited a £175,000 IHT residence nil rate band from his late spouse to go with his own band of the same amount.
His daughter, Jill, has a 45% marginal income tax rate and opts to take everything out of the fund. Here, the pension administrator will have to immediately pay £1.6m of IHT, leaving £2.4m in the fund. This remaining fund would then be paid to Jill, after withholding 45% tax.
Therefore, Jill will end up with £1.32m from the original £4m. This represents a 67% tax rate.
It gets worse, however, because the pension scheme assets also have the effect of tapering £350,000 of residence nil rate band down to nothing. This is effectively equivalent to another £140,000 of IHT on the pension scheme, meaning an effective tax rate of 70.5%.
Many individuals who have been relying on pensions being outside of their estates have refused to believe that this is how the rules will work.
Mr Marr added: “Unfortunately, case study five in the Budget notes unambiguously shows that the intention is for the rules to work in this way.
“We have seen many tax measures introduced over the years, but for certain families the impact of this one is massive and does smack of retrospective taxation. I use the word ‘retrospective’ because the individuals involved have reasonably believed that pension funds would be outside the scope of IHT and have often made contributions with IHT protection being a consideration.
“Also, as these rules are not set to kick-in until 6 April 2027, they will have the distasteful impact of old people becoming aware that dying after 5 April 2027 will have significant negative financial implications for the beneficiaries of their estates.
“As there is a consultation period before any legislation is drafted, perhaps there is a small chance of a government U-turn here before these rules are enacted (could this be a ruse to rile people up and then drop it to win favour in over two years’ time – a kind of political hedge?).
“In the meantime, this really does tip the balance on the decision of whether 25% tax free lump sums should be withdrawn from pensions.
“Anybody who thinks that they will leave unused pension funds should consider taking out the lump sum and gifting it. Even if they do not gift it, their beneficiaries would be saved a double layer of tax in the scheme when they die.”
